The ECB Should Pause Quantitative Tightening
Rising bond yields are putting pressure on public finances and the real economy. The central bank should stop adding to the strain. A commentary by Lorenzo Bini Smaghi
Over the past month, long-term interest rates have risen sharply across much of the world, particularly in the US but also in Europe.
Yields on 10-year US Treasuries, a benchmark for international markets, have risen by about 55 basis points to more than 5.2 per cent. That is higher even than in 2022, when US inflation exceeded 9 per cent.
On this side of the Atlantic, yields on long-dated government bonds have risen across Europe, led by France, with an increase of about 65 basis points, followed by Belgium with 48 and Italy with 45. Italy’s spread over German Bunds has approached 120 basis points, while France’s has neared 140.
Financial markets are beginning to show signs of concern.
These developments raise three fundamental questions.
The first is about the main causes of the rise. In fact, several factors are at work. One is the expectation that inflation will remain higher than anticipated for an extended period. When war broke out in Iran, there was a misplaced belief that the conflict would be short-lived because its adverse effects would jeopardise the US president’s prospects in the midterm elections. Instead, the conflict has dragged on, partly because its outcome no longer depends solely on the president’s wishes.
Another important factor is the fear among investors that central banks lack the independence needed to tighten monetary conditions and curb inflation. Decisions by the European Central Bank and the US Federal Reserve, as well as the Bank of Japan, which has long been reluctant to raise interest rates, have partly allayed those concerns.
Deteriorating public finances across most advanced economies, particularly the US, Germany and France, have also contributed to the rise in long-term rates.
The political difficulties of stabilising debt are prompting fund managers to reduce their holdings, particularly ahead of elections.
Private debt has also increased, notably to finance the enormous investment associated with the development and growing use of artificial intelligence.
In short, long-term rates are rising not only because demand for fixed-rate bonds is falling, in what some describe as a “sell-off”, but also because supply is increasing.
The second question concerns the impact on the real economy. Can growth continue with interest rates this high?
The answer depends on the sector. In the more dynamic industries associated with AI, the prospects for earnings growth make higher borrowing costs sustainable.
In more traditional sectors linked to household consumption, however, the burden of both higher interest rates and inflation is harder to bear. The housing market, which is particularly sensitive to financing conditions, is a case in point. It is no coincidence that consumer confidence has started to fall again over the past two months, both in Europe and in the US.
The enormous flow of investment into technology, increasingly financed by debt, is crowding out traditional sectors by raising their costs, particularly those of energy and borrowing. This resembles the “Dutch disease” of the 1970s, when the disproportionate expansion of the energy sector in the Netherlands undermined others, particularly manufacturing.
The final question is what economic policymakers should do in this environment.
Fiscal policy must avoid further increases in borrowing, which would only fuel inflation. Instead, it must reassure investors about the government’s creditworthiness.
For monetary policy, the overriding objective remains to curb inflation. At the same time, it must be attentive to financial stability, preventing a destabilising feedback loop between long-term interest rates and market confidence.
This is precisely why it is difficult to understand the ECB’s continued reduction of its balance sheet through so-called quantitative tightening. This exacerbates the imbalance between bond supply and demand, pushing long-term yields higher still. The time has come to pause, as other major central banks have decided to do.
It is equally difficult to understand why, with markets increasingly tense, especially in view of the upcoming elections in various countries, European governments have started discussing the succession at the top of the ECB, more than a year before the end of the term.
Rarely has it been more important to hold a steady course. This is no time to improvise.
A previous version of this article was published in the Italian daily Il Foglio
IEP Bocconi does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
